Accountability to the shareholder - the failure of corporate governance

Wall Street 1987, Gordon Gekko Teldar Speech:

"The new law of evolution in corporate America seems to be survival of the unfittest. Well, in my book you either do it right or you get eliminated."
...
"America, America has become a second-rate power. Its trade deficit and its fiscal deficit are at nightmare proportions. Now, in the days of the free market when our country was a top industrial power, there was accountability to the stockholder. The Carnegies, the Mellons, the men that built this great industrial empire, made sure of it because it was their money at stake."

The former Chairman of the FSA made an interesting speech in 2003, in relation to Corporate Governance in Financial Intitutions. What is interesting is the content of his speech. I have pulled some extracts below. It is very interesting to look at the failure of corporate governance in the light of the recent financial crisis we have witnessed. Have we really learnt from it?

Corporate Governance in Financial Institutions:
Speech made by Howard Davies, former Chairman of the UK Financial Services Authority , 3rd of June 2003.

http://www.fsa.gov.uk/Pages/Library/Communication/Speeches/2003/sp132.shtml



"There is not as much systematic and useable analysis of the reasons for failure in financial institutions as one would like. But there are some helpful sources.

European banking supervisors studied a number of banking problems across the continent between 1988 and 1998. Their overall conclusion was that management and control weaknesses were underlying, fundamental and contributory in almost all of the cases they considered.

A very similar conclusion was reached by a group of European insurance supervisors who looked at 21 cases of failure or near failure in European insurance companies between 1996 and 2001. (One astonishing feature of the work was that there were, during that 5-year period, a total population of 270 cases to consider, from which that selection of 21 were made.)

That report shows that there were usually a number of contributory causes to the collapse of an insurer. Poor underwriting practice, or inadequate reserving, was often the proximate cause of failure. But in all the case studies underlying management or governance causes were identified, in many cases relating to significant systems and controls issues. The widespread underwriting or asset problems were able to arise because of these fundamental weaknesses, and the combination of poorly managed risks made firms particularly vulnerable to adverse external events.

•When the group compared problem cases with other firms who weathered similar circumstances better, a pattern emerged of the following four forms of management malfunction:
•Incompetence, with firms straying outside their field of expertise or uncritically following the herd instinct.
•Excessive risk appetite, or objectives that were at odds with the prudent management of the business;
•Lack of integrity, or
•Lack of autonomy and inappropriate pressure for short-term results from, perhaps, the parent company.

Following my distinction between management and governance problems, I see governance issues in at least 3 of these 4 cases. Certainly a Board should identify the risks involved in companies straying outside their field of expertise, should ensure that there are no incentive structures in place which promote excessive risk-taking, and should ensure that the business does not come under inappropriate pressure to maintain earnings or market share."

All the above points raised by Howard Davies seems to indicate what went wrong with regulators in trying to mitigate the risk appetites of some of the financial players they were supposed to regulate. The regulators failed.

Howard Davies also added the following:

"A third interesting source can be found in the New York Fed’s most recent economic policy review, published in April of this year. It was a special issue entitled "Corporate governance: what do we know and what is different about banks?"

The volume includes a series of interesting analytical pieces, by different hands. They all, from different perspectives, try to assess just how much relationship there is between good governance and corporate success. As that, after all, is what ought to interest shareholders, not elegant governance per se.

One of the papers concludes that Board composition does not seem to be a useful predictor of firm performance. That is an interesting conclusion given the focus on Board composition in some of the codes. On the other hand, they found that in the US, at least, Board size does have a negative relationship to performance. In other words, the bigger the Board, the poorer the results."

Howard Davies goes on:

"Some of the bankers among you might welcome this conclusion. But I ought to add that one of the pieces in the Fed’s report argues that "a clear case can be made for bank directors being held to a broader, if not higher standard of care than other directors". Essentially, their point is that there are important stakeholders in banks other than shareholders – including major creditors and other institutions, given the safety net. The same authors go on to argue that, as a result, they support "a hybrid approach to corporate governance in which most firms are governed according to the US model, while banks are governed according to a variant of the Franco-German paradigm"."

Howard Davies also make an interesting point in his speech:

"Our experience shows, for example, that a dominant chief executive, or indeed business head, who is not effectively challenged by the Board or his colleagues, is a danger sign. Similarly, a Board lacking in relevant experience is unlikely to act effectively as a constraint on excessive risk taking."

His final conclusions in his speech made in 2003, indicates how corporate governance failed in financial institutions. Most of Howard Davies recommendations were not followed.

The failure of appropriate corporate governance is leading to a sigificant welcomed shareholder activism:

http://www.investmentweek.co.uk/investment-week/news/1360340/f-c-highlights-corporate-governance-failures

From this article:
Karina Litvack, head of governance and sustainable investment at F&C, says: "We believe that a failure in governance lies at the heart of the banking crisis. The events of the last few months have confirmed that the soaring pay packages for top bank executives were driven by extraordinary risk-taking rather than real, sustainable profits. Investors can be part of the solution, by spotting red flags and using their influence as shareholders to press for better governance practices."

Corporate Governance failed mostly because regulators failed to do what they are paid for: regulate. In May 2009, Stephen Friedman resigned as Chairman of the New York Fed’s Board of Directors.
The reason of his resignation was the following:

http://inthesenewtimes.com/2009/05/04/new-york-fed-chairmans-ties-to-goldman-raise-questions/


"The Federal Reserve Bank of New York shaped Washington’s response to the financial crisis late last year, which buoyed Goldman Sachs Group Inc. and other Wall Street firms. Goldman received speedy approval to become a bank holding company in September and a $10 billion capital injection soon after.

During that time, the New York Fed’s chairman, Stephen Friedman, sat on Goldman’s board and had a large holding in Goldman stock, which because of Goldman’s new status as a bank holding company was a violation of Federal Reserve policy.

The New York Fed asked for a waiver, which, after about 2½ months, the Fed granted. While it was weighing the request, Mr. Friedman bought 37,300 more Goldman shares in December. They’ve since risen $1.7 million in value."

If the regulators cannot even regulate themselves and avoid conflict of interests, how are they supposed to do their job properly?

http://mostlyeconomics.wordpress.com/2009/05/08/new-york-fed-corporate-governance-failure/


The author of this blog raise an important point? How can an entity like the New-York Fed can properly regulate financial institutions when 6 of the members supposed to represent the public representatives are from the very same financial institutions?

In addition to corporate governance, disclosure of information, adds transparency and would alleviate concerns and restore trust in the system.
There is an ongoing legal battle of great interest currently happening in the US relating to the access of the financial institutions to the Fed Discount Window during the Financial crisis:

http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=aUQp2owUUueA


"The Federal Reserve won’t join a group of the largest commercial banks in asking the U.S. Supreme Court to let the government withhold details of emergency loans made to financial firms in 2008."
...

"The bank group is appealing a federal judge’s August 2009 ruling requiring the Fed to disclose records of its emergency lending. Bloomberg LP, the parent company of Bloomberg News, sued for the release of the documents under the Freedom of Information Act.

The central bank has never disclosed the identities of borrowers since the creation in 1914 of its Discount Window lending program, which provides short-term funding to financial institutions, the Clearing House said in its petition."

Would transparency do more harm than good? This is what the bank group thinks according to this Bloomberg article.

“Greater transparency results in more accountability, and the banks’ resistance continues to engender suspicion among taxpayers about the bailouts,” said Matthew Winkler, Bloomberg News editor-in-chief.

It is very important to track the results of this appeal. If it leads to full disclosure, it will give a great insight into the difficulties faced by many insititutions during the crisis.

It is indeed a very sensitive issue.

The Great Pretender - the Bluff Call of 1971 - the Nixon shock.

In 1971, one of the greatest poker game ever played came to halt. It marked the end of the Gold Standard and the convertibility of the US dollar in Gold.

In this post I will revisit this great moment and highlight some of the contributions of one of the great adversary of Keynes to this moment, Jacques Rueff.

The context of the Nixon Shock of 1971:

http://en.wikipedia.org/wiki/Nixon_shock

"By the early 1970s, as the costs of the Vietnam War and increased domestic spending accelerated inflation, the U.S. was running a balance of payments deficit and a trade deficit, the first in the 20th century. The year 1970 was the crucial turning point, which, because of foreign arbitrage of the U.S. dollar, caused governmental gold coverage of the paper dollar to decline from 55% to 22%. That, in the view of Neoclassical Economists and the Austrian School, represented the point where holders of the U.S. dollar lost faith in the U.S. government’s ability to cut its budget and trade deficits.

In 1971, the U.S. government again printed more dollars (a 10% increase) and then sent them overseas, to pay for the nation's military spending and private investments. In the first six months of 1971, $22 billion dollars in assets left the U.S.[citation needed] In May 1971, inflation-wary West Germany was the first member country to leave the Bretton Woods system — unwilling to deflate the Deutsche Mark to prop up the dollar. In order to prevent the dumping of the Deutsche Mark on the open market, West Germany did not consult with the international monetary community before making the change. In the next three months, West Germany’s move strengthened their economy; simultaneously, the dollar dropped 7.5% against the Deutsche Mark.

Because of the excess printed dollars, and the negative U.S. trade balance, other nations began demanding fulfillment of America’s “promise to pay” - that is, the redemption of their dollars for gold. Switzerland redeemed $50 million of paper for gold in July. France, in particular, repeatedly made aggressive demands, and acquired $191 million in gold, further depleting the gold reserves of the U.S. On 5 August 1971, Congress released a report recommending devaluation of the dollar, in an effort to protect the dollar against foreign price-gougers. Still, on 9 August 1971, as the dollar dropped in value against European currencies, Switzerland withdrew the Swiss franc from the Bretton Woods system."

The great imbalances we have witnessed in the last couple of decades come from this defining moment of the summer of 1971, when the great poker game played by the US came to halt as more and more countries called their bluff, worried by the US deficits. The agressive demands coming from France had been initiated by the advisor of General de Gaulle, Jacques Rueff, Keynes greatest opponent.

"The conditions which formerly were able to give rise to the ‘gold exchange standard’ have changed. The currencies of the Western European States are restored, to the extent that gold reserves of the Six today equal those of the Americans … This means that the custom of ascribing a superior value to the dollar as an international currency no longer rests on its initial foundation – I mean America’s possession of the largest share of the world's gold. This unilateral facility which is granted to America is serving to cloud the idea that the dollar is an impartial and international medium of exchange, when it is a means of credit belonging to one State … Gold has real value."

- Charles de Gaulle, February 4, 1965.

With great power comes great responsibility.
Stan Lee - Spiderman

The abuses of Bretton Woods.

The US have behaved irresponsibly for too long, putting us all at risk.

The privileged status of the US which was granted under the Bretton Woods arrangements, made it possible for the US to run a deficit that would never disappear while the dollar standard prevailed. Jacques Rueff concluded that this privileged status would inevitably lead(dollar standard and associated deficits) to a global economic crisis that would end in tears, an event akin with the Great depression. This is the situation we are currently going through.

Jacques Rueff has proven to be right and the Keynesians dangerously wrong.

A recently published biography on Jacques Rueff by Christopher Chivvis, The Monetary Conservative, is reviewed using the below link. It gives you a brief insight on Rueff's belief and contributions to economic policies:

http://www.realclearmarkets.com/articles/2010/09/14/book_review_the_monetary_conservative_by_christopher_s_chivvis_98667.html
http://74.217.243.103/publications/pubID.2261/pub_detail.asp

The clear abuse from the Dollar domination was very clear with the 1985 Plaza Accord of the 22nd of September 1985. I went through the consequences for Japan in a recent post relating to the bogus currency wars and the attitude of the USA towards China. Japan's never fully recovered from the economic suicide they committed by allowing the Yen to rise very fast again the US dollar.

The US survived the Saving and Loans Crisis by pushing Japan to the floor, and ruining in the process their largest creditor at the time. The US are attempting the same game with China today, this time around let's all hope they will fail. China is trying to curb hot money pouring in as well as taming inflation. They recently raised one year lending rate to 2.5%. It is becoming extremely difficult for China to slow hot money flows. Some countries have already implemented capital controls.

For Jacques Rueff, the only solution to remove the great current imbalances, would have been to reform the system and avoid a currency like the US Dollar to play the role of the world's leading currency or any other currency. Would a return to a Gold Standard work? Or a Bancor currency as advocated by Keynes? Bancor was indeed proposed before Bretton Woods led to the US Dollar assuming the role of the World's currency. Both Rueff and Keynes did not want the US Dollar to be the prevailing currency. They both understood the risks.

Tim Geithner's latest proposal targeting trade deficits and surpluses is basically an attempt to go back to Keynes Bancor proposal.

Felix Salmon recently wrote a post on Geithner's proposal in Seeking Alpha:

http://seekingalpha.com/article/231671-tim-geithner-s-poor-imitation-of-john-maynard-keynes

"Tim Geithner has proposed to his fellow G-20 finance ministers that trade surpluses and deficits be capped at 4% of GDP. The idea is already running into criticism from countries that run big trade surpluses."

QE2 is the nuclear option the US are currently playing with. They are willing to export inflation to the emerging markets to force their hands.

Ambrose Evans Pritchard in an article published in the Telegraph on the 10th of October discuss what is currently happening, paving a road to a potential new Bretton Woods, and the removal of the US Dollar as world reserve currency.

http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/8054066/Currency-wars-are-necessary-if-all-else-fails.html

"The atomic bomb, of course, is quantitative easing by the Federal Reserve. America has in effect issued an ultimatum to China and G20: either you stop this predatory behaviour and agree to some formula for global rebalancing, or we will deploy QE2 `a l’outrance’ to flood your economies with excess liquidity. We will cause you to overheat and drive up your wage costs. We will impose a de facto currency revaluation by more brutal and disruptive means, and there is little you can do to stop it. Pick your poison."

The US are playing the Great Pretender game.

The United States has had the luxury of being in a position to avoid economic adjustment in spite of its deficits for too long. It is time to adjust to the reality and stop pretending.

The Great Pretender
The Platters/Freddie Mercury:

Oh yes I'm the great pretender (ooh ooh)
Pretending I'm doing well (ooh ooh)
My need is such I pretend too much
I'm lonely but no one can tell

Oh yes I'm the great pretender (ooh ooh)
Adrift in a world of my own (ooh ooh)
I play the game but to my real shame
You've left me to dream all alone
...

Another farewell to a great mind - Benoit Mandelbrot

Benoit Mandelbrot: 24th November 1924 - 14th of October 2010.


One week on and another loss of one of the greatest minds. It is a very sad October.

He was the inventor of Fractal Geometry.

Mandelbrot was Nassim Taleb's mentor.

http://www.youtube.com/watch?v=DLFkQdiXPbo

http://www.fooledbyrandomness.com/

"A Greek among Romans".

One of the greatest book written about Markets is the below:

The (Mis)Behavior of Markets: A Fractal View of Risk, Ruin, and Reward, by Benoît Mandelbrot and Richard L. Hudson; Basic Books, 2004; ISBN 0-465-04355-0

It was published before the Black Swan and Fooled by Randomness.

Benoit Mandelbrot was one the greatest.

Thank you for opening up my mind to the perception of risk.